Michael S. Weisbach is a Stanley C. and Joan J. Golder Professor of Finance and academic director of the Stanley C. Golder Center for the Study of Private Equity.
Michael S. Weisbach is a Stanley C. and Joan J. Golder Professor of Finance and academic director of the Stanley C. Golder Center for the Study of Private Equity. He discusses some of the underlying reasons for the turmoil in the financial markets. He was interviewed by News Bureau Business and Law Editor Mark Reutter.
Financial problems that once seemed limited to the home mortgage industry have now spread to investment funds controlled by American and European banks. This in turn has spooked stock markets around the world. What’s going on?
Mortgages are typically packaged and “securitized,” which means that they can be bought and sold like stocks or bonds. What happened a few years ago is that people who shouldn’t have been qualified for a mortgage were given mortgages anyway. The people who gave them the loans didn’t care, because they were able to sell the mortgages to unsuspecting investors. At the time, interest rates were very low, and investors were looking for higher yields than government bonds. Mortgages provided that higher yield. Now, many institutions realize that they are holding these mortgages, which are beginning to default. On August 9, three investment funds at the big French bank BNP Paribas, which had invested in American mortgage securities, stopped redeeming funds to their investors. When this news became public, stock markets around the world fell sharply.
The surge in leveraged, or high-debt, buyouts of large companies may also come back to haunt some banks and investment funds. Did the temptation of high fees and quick returns blind the financial community to the risks of paying too high a premium for corporate acquisitions?
A consequence of events in the mortgage market is that lenders have become very wary of other kinds of risky debt, such as debt used in recent years to finance corporate leveraged buyouts. Some of my recent research has documented how the availability of “easy money” has led to the growth of the buyout market, both in terms of the number of deals and the prices paid for these deals. What we are now seeing is a shakeup in this market. There will likely be fewer buyouts in the next few months, and those that do occur will be at lower prices (in terms of valuation multiples) than we have seen in the last year or two.
What’s the “cure”?
There isn’t really a cure. But markets do have this way of taking care of themselves. Investors probably will be scared of risky debt for a while, but, eventually, will start supplying capital for deals again, provided that the potential returns justify the risks.
